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Drafting tip: Don’t let a termination clause allow your client to score an own-goal

Here’s a contract-drafting decision that backfired: A software-development contract between a software developer and a hardware company (apparently) included typical provisions allowing the hardware company to terminate the contract if the software developer failed to meet deadlines. The hardware company sent a notice of termination to the software developer on grounds of material breach by the developer. But a court held that the other party hadn’t breached after all — and therefore the hardware company, by sending the notice of termination, had itself materially breached the contract. As a result, the hardware company ended up losing its ownership interest in the software.

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In Automated Solutions Corp. v. Paragon Data Sys., Inc., a computer-hardware company entered into discussions with the Chicago Tribune about developing a handheld computerized inventory device for the Tribune’s newspapers. The hardware company reached out to a software developer with which it had worked before.

The hardware company and software developer entered into a contract with the Tribune to develop the inventory device. Separately, the software developer entered into a license agreement with the Tribune to develop the software. And the Tribune wanted to get invoices from a single party, so the hardware company and software developer agreed that the hardware company would handle invoicing and pay the software developer its proper share.

The software-development work didn’t get finished by the agreed deadlines, in part because as the work progressed, the Trib got a better idea of what it wanted and made changes to the agreed specifications. The software developer also learned that the hardware company, which had been the one sending invoices to the Trib, had been short-paying the software developer for its part of the work.

The hardware company and the software developer entered into a letter agreement to get things back on track. But in time the hardware company sent the software developer a notice of termination of their agreement for material breach.

That notice of termination ended up being an own goal on the hardware company, because:

  • An Ohio state court held that the hardware company’s termination of the agreement had been improper, and amounted to a repudiation of the agreement, because the software developer hadn’t been in breach, because the Tribune had waived the development deadlines.
  • That in turn gave the software developer the right to rescind its agreement with the hardware company — which it did.
  • Consequently, held a state court, the hardware company — whose project it had been to start with, remember — no longer had any right to distribute the software for the inventory device.

See Automated Solutions Corp. v. Paragon Data Sys., Inc., 2006 Ohio 3492 (Ohio App. 2006) (affirming judgment after bench trial).

Incidentally, that wasn’t the end of the bitterness between the hardware company and the software developer. Deprived of the right to distribute the software developer’s work product, the hardware company hired a programmer and developed its own software for the inventory device. In response, the software developer sued the hardware company for copyright infringement. Eventually, a federal trial court granted summary judgment in favor of the hardware company, on grounds that the software developer had failed to specify which protectable parts of its software had allegedly been infringed. See Automated Solutions Corp. v. Paragon Data Sys., Nos. 13-3025 and 3058 (6th Cir. June 25, 2014) (affirming summary judgment in favor of Paragon).

Drafting tip: Include more-calibrated remedies than just termination

In hindsight, it seems clear that the hardware company shouldn’t have sent a notice of termination. But it’s easy to imagine (unburdened by any factual knowledge) that the hardware company’s business people might have been so [ticked] off at the software developer that they insisted on terminating the contract, because (supposedly) that’s what you do when a contract relationship goes south.

Again with 20-20 hindsight, perhaps the hardware company would have been better off if the contract, rather than handing the hardware company’s business people the dangerously-blunt instrument of termination, had instead included more-sophisticated remedial provisions allowing the the hardware company to do what it wanted to do without “terminating” the contract.

Which brings to mind something that my late senior law partner, mentor, and friend, Tom Arnold, told me when I was a baby lawyer: Contracts per se should never terminate — only specific rights and obligations should come to an end.

It also illustrates another point: Sometimes clients need to be protected from themselves, which omitting a termination-for-breach clause might have helped to do here.

Comments on this entry are closed.

  • Chadwick Busk 2014-06-30, 6:52 pm

    Hmmm. Interesting case and a perceptive analysis. Termination for breach can backfire and should be regarded as a “doomsday” remedy. Perhaps all parties would have been better off if the Trib had separate contracts with the hardware company and the developer rather than rely on the hardware company to basically sub the development work out.

  • D. C. Toedt 2014-06-30, 7:02 pm

    Thanks, Chadwick Busk. I suspect, though, that the Trib really didn’t want to get involved with being its own general contractor. In hindsight, maybe the software developer should have gotten the Trib to send it (the software developer) copies of the checks it paid the hardware company, or something like that. To quote an old saying from the nuclear Navy, “you don’t get what you expect, you get what you inspect.”

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